ABS

Ratings Arbitrage - Letting the Credit Ratings Agencies off the Hook

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An amendment just passed the Senate which allows regulators to assign a credit rating agency to evaluate asset based securities. To date, the ones hiring the credit rating agencies are the ones making up these fictional derivatives.

That said, we have this New York Times article reporting more investigations of banks, but this time trying to find evidence the poor little ole' credit ratings agencies were just played as suckers by the banks (cough, cough):

The New York attorney general has started an investigation of eight banks to determine whether they provided misleading information to rating agencies in order to inflate the grades of certain mortgage securities, according to two people with knowledge of the investigation.

Since ratings models were available to the ones creating the structured finance product, in this case, credit default obligations (CDOs), issuing firms could analyze the ratings methods to figure out where to hide the toxic, worthless crud contained within, yet still land a AAA rating.

CDOs Backed by Risky Mortgages now Worth 5% of their value

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Remember those toxic assets and how the government was going to buy them up, sell them later to recover their value?

You must read this Financial Times article:

Here is the Magic Secret Decoder Ring to translate:

CDO - Collateralized debt obligations
Mezzanine - Underlying asset is subprime, "risky" mortgage
ABS - Asset backed securities
Tranche - Slices of risk levels within a bundled group of securities

From late 2005 to the middle of 2007, around $450bn of CDO of ABS were issued, of which about one third were created from risky mortgage-backed bonds (known as mezzanine CDO of ABS) and much of the rest from safer tranches (high grade CDO of ABS.)

Out of that pile, around $305bn of the CDOs are now in a formal state of default, with the CDOs underwritten by Merrill Lynch accounting for the biggest pile of defaulted assets, followed by UBS and Citi.

The real shocker, though, is what has happened after those defaults. JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO’s, though, recovery rates on those AAA assets have been a mere 5 per cent.